The U.S. has regained more than 90 percent of the jobs lost during the pandemic, and hiring continues at a strong pace, constrained only by the supply (or shortages) of labor. The recent data show 431,000 jobs added during the month of March, while the unemployment rate fell to 3.6%. There are only five months on record where the unemployment rate has been lower. The negative impact of the virus appears mostly behind us, as a majority of Americans likely have some immunity from vaccination, infection, or both. Consumer spending is particularly strong, especially in the sectors that were hardest hit during the pandemic, such as travel and leisure. As the warmer weather approaches, there is a good deal of pent-up demand in discretionary spending to make up for the experiences (e.g. travel, dining out) that were put on hold amid the pandemic. As the pandemic fades in the U.S. and spring progresses into summer, it will likely add momentum to the recovery. The trouble is, everything costs more; demand for all sorts of goods and services – cars, lodging, restaurant meals – has outstripped supply, leading to the fastest rate of inflation in 40 years. With so many forces pulling in different directions, the state of the world is not altogether back ‘in balance.’ All of these factors have the Federal Reserve on high alert. The crisis in Ukraine has added an additional shock, sending oil and commodity prices soaring, along with general uncertainty, which complicates the Fed’s anticipated response. While the fundamental drivers of continued economic expansion remain intact, we expect inflationary pressures to weigh on economic growth in the near-term, resulting in a deceleration of the growth trend moving forward.
Given this backdrop, we expect the expansion to continue, but growth to moderate in the coming months. Though the recovery from the pandemic recession has been very bumpy, by the end of 2021 the U.S. economy finally surpassed the pre-pandemic level of overall economic output. Part of the reason for this is due to the ways that the pandemic required us to adapt. Although demand for some goods and many services collapsed during the pandemic, workers became much more productive. Over the past two years, output per worker has grown at an annual rate of 2.7%, more than twice the 1.2% growth seen in the first two decades of this century. Many of the pandemic-related adaptations are here to stay, such as the trend towards virtual meetings, on-line shopping, and flexible work routines. We think it is likely that most of the productivity gains will persist even as the pandemic recedes.
Early indications suggest that the Omicron variant caused growth to slow below 2% in the first quarter of 2022. However, we expect stronger growth in the second quarter spurred by the aforementioned increase in both consumer and business spending. Thereafter, growth will likely fade as the economy reaches capacity limits, and financial conditions become tighter (e.g. higher mortgage rates). Economic growth is widely expected to end the year at close to 3% (real GDP growth), which we expect will slow to about 2% early next year. While 2% growth is in line with long term historical trends, this lower figure means that the economy will be more at risk to a variety of shocks, raising the potential for a contraction in 2023.
The supply of labor is key to understanding the capacity limit to growth. Simply put, there is an enormous mismatch between the demand for labor and the supply of willing and qualified workers. With an estimated 11.3 million job openings, and only 6 million unemployed, there is a shortage of about 5 million workers. Part of this shortage is due to the so-called Great Resignation, as pandemic life caused people to reassess their work/life priorities. Demographics also play a role in shrinking the labor force. This mismatch has put significant upward pressure on wages, which spiked 6.7% year-over-year in March. Continued upward pressure on wages aggravates broad underlying inflation trends.
Rising wages, fading pandemic effects and the elimination of most pandemic assistance from the government should draw more workers back into the labor force and lead to further declines in the unemployment rate. By the end of this year, it is possible that the unemployment rate will fall below 3.4%, making it the lowest unemployment rate since 1953.
Inflation is front and center for the Fed, which has revamped its inflation playbook in recent weeks. Gone is the view that elevated inflation is mostly “transitory,” and the Fed has started to take action. With the recent energy shock contributing to the problem, the Fed is now poised to raise interest rates about twice as quickly as it had forecasted at the end of last year and perhaps faster than that. After falling well behind market expectations, the Fed has gotten the message and is trying to catch up. The consensus, as implied by the fed funds futures market, is that the fed funds rate will rise to about 2% by the end of the year, as it aims to bring inflation closer to its 2% long-run target. By the end of 2022, we expect most of the supply chain issues to normalize, allowing headline inflation (that includes food, energy, and auto prices) to ease. However, the longer high inflation persists, the stickier it gets, which means the Fed will keep raising rates until it succeeds in bringing inflation under control. The challenge will be to achieve this result by lowering aggregate demand just enough but not too much, so that the economy avoids slipping into recession. The odds of recession in 2022 are quite low, but recession is a greater potential concern in 2023, depending on how these myriad factors play out in the year ahead.